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Forget Carried Interest--It's All About Taxing Capital Gains

For a complex tax issue, carried interest sure gets a lot of media attention. That's probably because it involves many very rich hedge fund managers -- the kind of people who everyone loves to hate, admire, and envy, thanks to their "hugely outsized earnings."

But the debate over how to tax profits earned by the titans of private equity, while diverting for a certain kind of tax lawyer, is actually irrelevant to the rest of us. Or at least it should be. The only issue that really matters is how we tax capital gains.

Most arguments over carried interest are definitional: Does a given chunk of money actually qualify as a capital gain, or is it more accurately viewed as labor income? The answer matters, since labor income pays full freight under the personal income tax, while capital gains are taxed at lower rates. And by lower I mean roughly half.

Very smart lawyers make very long arguments about why carried interest should be treated as a capital gain. Other very smart lawyers make other very long arguments about why carried interest should be treated as ordinary income.

All these arguments are great for the tax lawyers who make them (especially since some of these experts are getting paid by the hour to write this stuff). But they aren't so useful for the rest of us, since they take something crucial for granted: the existence and legitimacy of the capital gains tax break itself.

The capital gains preference is usually defended on pragmatic grounds, with supporters insisting that it encourages productive investment and economic growth. Some fans also make a fairness argument, saying that capital gains are overtaxed when treated as regular income, since some capital gains are taxed more than once and all are taxed without regard for inflation.

All these justifications are debatable. Economists disagree about whether the preference actually encourages investment, and the fairness arguments -- while compelling in some respects -- are also problematic (especially since many capital gains, rather than being taxed repeatedly, are never actually taxed at all).

But one thing is not debatable: If you're worried relative tax burdens, the capital gains preference is a problem. After all, it's the capital gains break that allows Warren Buffett to pay tax at a lower average rate than his secretary. More generally, the preference reduces the average tax rate for anyone earning money from investments. People with lots of investments see a particularly big reduction -- people with names like Buffett, Bezos, Gates, and Gross.

This last name is significant, since Bill Gross, cofounder of PIMCO and manager of the world's largest bond fund, recently called for an end to the capital gains preference. "The era of taxing 'capital' at lower rates than 'labor' should now end," he wrote recently. Gross specifically called for an end to the carried interest tax break, but he also made the more general argument. The time has come, he said, to implement "more equitable tax reform that equalizes capital gains, carried interest and nominal income tax rates."

More equal taxation, Gross insisted, would bolster not only fairness, but the economy, too. "Developed economies work best when inequality of incomes are at a minimum," he wrote. In other words, everyone would gain from more equal taxation -- including hedge fund managers.

If surging inequality is our most serious problem, then abolishing the capital gains preference would be a step in the right direction. (Although it wouldn't be a panacea, given the many factors that seem to drive inequality, including education, de-unionization, globalization, and technological change).

But my current point is a smaller one. If our immediate problem is tax fairness, abolishing the capital gains preference is crucial.

People get outraged when hedge fund managers pay too little to Uncle Sam. But it's not just the Wall Street guys and their fancy compensation arrangements. It's anyone earning a big chunk of their total income in the form of capital gains. That includes bond traders, sure, but widget builders, too.

Rich people pay too little in taxes, at least when compared with the rest of us. And the richer they get, the less they pay (in terms of their tax rate, not actual dollars). We should be talking about how to fix that problem, not how to tame Wall Street.

Because once we fix the big problem, the little one goes away.

Read Comments (5)

bubba shawnNov 5, 2013

Turning capital gains taxable income into ordinary taxable income will hit a
"Berlin wall" of resistance from durable goods manufacturers like Caterpillar
and Boeing. Machine tool manufacturers will also scream bloody murder.

Joseph, what you are attempting to label as "fair" is recklessly irresponsible
to say the least.

Warren Buffett's low tax rate is also attributable to his large holdings of
tax-free municipals. You need to include an end to that loophole in your quest
for "fairness." Also, his secretary's tax rate is "double" his because it
includes both the employer and employee Social Security taxes. So, the
comparison is actually bogus. She's really paying 20%, and his capital gain
tax rate has already been lifted to 23.8% this year.

I would be very happy to have capital gain and labor taxed at the same rate, so
long as that rate was no higher than 28%. That's the rate enacted on a
bipartisan basis in 1986, and that rate unleashed tremendous economic growth.
Higher rates than 28% on capital gains have historically led to substandard
economic growth.

I would also love to ditch the estate tax in favor of taxing unrealized gains
at death, at whatever the capital gains tax rate is at that moment. That would
eliminate your problem of some gains going untaxed. For simplicity, I would not
excuse "small estates" or married couples from this levy, it would just go on
the decedent's final income tax return. Trouble is, that would put too many
tax lawyers out of business.

If we simply restored the tax code to its 1987 status, word for word, we'd be
in a much fairer, simpler place that we are now, with our bevy of surtaxes,
loopholes and phase-outs. That 1987 tax code, by the way, raised plenty of
revenue also. More than enough for the legitimate functions of the federal
government.

Bubba Shawn seems to have the tax concept of capital asset mixed up with the
economics concept of capital asset. Joseph has a really good point. Our tax
system treats income earned from invested capital far better than income earned
from labor. What do we really have to show for it?

Edmund, the 1987 tax code would be insufficient to fund government as it is
now. Technically speaking, it was insufficient to fund government then, but
balanced budgets were not a conservative plank then so no one seemed to care.

Venture capital is investing in risky start up enterprises to be rewarded for
their capital investment. That reward is either a capital gain or capital
loss. The IRS Code doesn't distinguish between a manufacturer of durable and
non-durable goods or a labor intensive service enterprise like a call center
except that people are not depreciated.

another example is where my point focuses upon the transactions of durable
goods. Company A considers the NPV including tax consequences in machine
purchases from company B in their due diligence on the economic benefits of
that purchase.

Changing the capital gains tax rates to equal ordinary income tax rates will
result in lost jobs to company A because company B deems that purchase too
expensive in terms of NPV.

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